Factor investing works

Factor investing is in vogue. Investors are increasingly focusing on factors such as value, low volatility, momentum and small cap. But what do we know about the relevance of factor investing?

Joop

Huij

Portfolio Manager, Head of Factor Investing Equities and Factor Index Research

Many studies have looked at the concept of factor investing. But how does it work in practice? Robeco quantitative researcher, Joop Huij, examined the data of approximately 7000 funds over the 1990-2010 period. His goal was to find out whether active managers with exposure to factor-based investment strategies consistently outperform their benchmarks. He used a regression-based method to show fund exposure to factors. “The results indicate that factor investing works in practice.”

How important is factor investing for active management?

My observation is that while factor investing can be highly effective, this does not necessarily hold true for all factors. You can turn the odds of success to your advantage by investing in proven factors. We therefore need to find out which factors do and which do not work. Some factors have been studied very thoroughly. Take, for example, value and low volatility. For these factors there seems to be consensus on the existence of statistical patterns and their significance after taking trading costs into account. For some factors there is also a vast amount of research into the reasons behind their existence. However, other factors such as short-term reversal and long-term reversal are still relatively unknown and there is as yet no academic consensus on their significance. These less-known factors also formed part of this study.

While we see many mutual funds in our database exposed to the small cap and value factors, other factors are less popular. For instance, only 6% of all active-management strategies in our database are identified as low-volatility strategies. Within this 6%, only a small minority consciously engages in this strategy, for example by including screening on volatility. Only 1 to 2% of the mutual funds consistently follow a momentum strategy.

Are all factors doing well?

No. Short-term reversal is showing very poor performance. A short-term reversal strategy is designed to benefit from stocks that have performed badly in the recent past, but will outperform in the near future, or the reverse. A theoretical explanation for this is overreaction to stock-specific news by investors. However, 96% of all short- term reversal funds underperform the market. This outcome is not a complete surprise, since this strategy requires frequent portfolio rebalancing, which leads to high trading costs that ‘eat’ into net performance.

The research shows that what works best is a more conservative approach to factor investing that considers only those factors for which there is a large amount of evidence, as anomalies don’t just disappear. This contrasts to what I sometimes hear in the market, where brokers may say: ‘’Better to invest now in the latest factor before it is arbitraged away. No point in waiting until all the evidence is there; and don’t be too critical.” But my research shows that some factors, such as short-term reversal, simply don’t work.

‘The results indicate that factor investing works in practice’

What are your findings on momentum?

If you look at momentum, you will see that 38% of active managers that include a momentum factor achieve outperformance. This is less than in the value or low volatility universe, but still substantially more than the group not exposed to any factors. However, we also show that some managers exposed to momentum generate substantial underperformance. This is not totally unexpected. The literature warns that momentum investing can be a high-risk strategy. You need to implement it well to be successful. It is important to avoid two major pitfalls: first, excessive turnover levels that result in high trading costs; and second, exposures to unrewarded risks that do not contribute to achieving extra performance.

What is the relevance of diversification to factor investing?

It is better not to invest in just one factor, but ideally to engage in diversification, because a single factor can result in underperformance in relation to the broad market for quite a considerable period of time.

Our study shows that a fund that does not engage in factor investing historically demonstrates underperformance by on average 189 basis points per annum. I would call this result alarming. In contrast, a fund that is exposed to one random factor earns 163 extra basis points. With two random factors, this increases to 334 basis points, and with three factors, the result is even better: an outperformance of 353 basis points per annum. If you do not follow a factor-investing strategy as an active manager, your chances of outperforming are 20%. If you invest in one factor, they increase to 51%. This relates to a random factor and a random manager. If you choose three random factors and select a random manager, your chances will increase to 80%. If you choose the right factor and the right manager, your chances of outperformance could be even higher.

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